Whatever Happened at VW?

 

by Ingo Walter

With the resignation of CEO Martin Winterkorn and his replacement by Porsche’s CEO, the firing of three key R&D bosses, the herds of prosecutors and tort lawyers hoping for years of litigation, and the ominous clouds overhead from the media, among regulators and customers – and not least investors who have lost up to 42% of the value of their shares - the VW scandal raises lots or questions that go way beyond the world’s largest car manufacturer itself. They concern corporate governance, management decision processes and individual accountability, the regulatory environment, as well as industry competitive structure and performance. A true learning moment.

As the proud owner of a VW Toureg turbodiesel, it also hits close to home. Happily for now, VW V6 diesels like mine have not been named in the fraud allegations. But that may just be because of the expensive urea-based technology to cut nitrogen oxide (NOx) emissions found in large diesels was what VW was trying to avoid using in small ones by relying a “magic” approach that nobody could replicate and that turned out to be fraudulent. Now pundits have proclaimed the “death of diesel,” probably prematurely and unfairly.

What next for VW? Examples from the banking industry suggest that "rogue" behavior in one firm often turns out to be "industry practice." Examples include manipulation of foreign exchange and Libor benchmarks, hedge fund “late trading” in mutual fund shares, mis-selling of “payment protection insurance to ordinary retail customers,” insurance broker kickbacks from underwriters, falsification of international payment transactions, aiding and abetting tax evasion, and the list goes on.

One firm gets tagged and the others run for the hills and take a very low profile until the posse rounds them up. That could be the case here also, with MB, BMW, Renault, Peugeot, etc. Some are saved (for the moment) because they focus on big or expensive cars able to support urea-based approach. Others focus on mass-market, cheaper diesels and may have encountered engineering problems similar to VW’s. They say they have not, that VW is unique. If not they will step up very soon. Last guy in is a reputationally rotten egg. So we’ll soon see whether the VW problem is in fact firm-specific or industry-wide.

Certainly the nitrogen oxide emissions remain an issue with the US and especially California most aggressive in putting on the regulatory pressure. The European approach seems to have been more retarded and haphazard by comparison, with heavy lobbing from the important car manufacturers and their governments. Travelers can tell you that the air pollution problem is pretty bad in parts of Europe. On a dozen or so days a year the speed limit in the Paris region is cut to 90 km/hr because of the health effects of NOx and particulates – in an air-shed where well over half the cars and almost all trucks are diesels. This is not a matter of engineering fraud but rather one of deficient emissions standards, but now that the VW cat’s out of the bag it points to things to come for the automakers.

To the outside observer it seems that what happened here is that the VW engineers got seriously squeezed between the marketing pitch for modern European common-rail diesels (fuel economy, durability, torque and environmental friendliness – much of it true) and the tightening noose of US environmental standards. This eventually made the two simply incompatible.

The engineers no doubt signaled the problem internally (how high up we don't precisely know) and senior management told them to fix it or else. So they were trapped. Pressed to the wall, the engineers came up with a workaround. Whether in the whole process anyone raised the full range of potential consequences including the possibility of individual criminal charges we also don't know. Anyway, decisions got made somewhere. Under German law such matters tend to move quickly into the criminal domain where unlike in the US firms cannot be charged in civil proceedings (and allow a range of punitive options, possibly including criminal pleas by firms themselves) but rather are targeted on the individual.

So the otherwise walk-on-water CEO has walked the plank instead and may be personally charged (famously, this has rarely happened in banking).

Some Europeans have blamed the US regulatory approach and litigiousness for triggering the brouhaha. In Europe it would have been taken care of in a sensible way by corporate specialists talking to regulatory specialists, eventually arriving at a mutually acceptable solution. Maybe so. But they said the same thing in the FIFA mess.

Two Questions Raised by the VW Case

by Roy C. Smith

The VW case will raise two questions for sure: is someone going to jail?, and what should be expected of boards of directors in preventing corporate misconduct?

Last month Volkswagen’s Supervisory Board asked for the resignation of CEO Martin Winterkorn and said it was investigating the company’s engineering staff to pin down responsibility for the installation of the “defeat devices” used for seven years to disable emission controls on 11 million diesel engine cars sold in the US and Europe. The devices were installed to boost performance standards for the cars that VW emphasized in its advertising. Prosecutors in Germany, the US and Sweden and other countries are investigating the situation for possible criminal violations.

Meanwhile, market analysis have estimated VW’s potential all-in costs of fines and legal settlements to be in the $18 to $20 billion range, roughly equal to the loss of about $25 billion, or a third of the company’s market capitalization since the admission was made to the US Environment Protection Agency on September 18th. VW has taken an initial $7.5 billion charge to its legal reserves to cover the exposure.

This is likely to be the biggest self-inflicted corporate disaster since BP’s 2010 Deepwater Horizon oil spill in the Gulf of Mexico that has cost it $28 billion so far. BP’s market capitalization is about $70 billion less (35%) than what it was in 2010.

Going to Jail

Senior corporate executives do go to jail for their actions. The former CEOs (and other executives) of Enron, WorldCom, and several other companies from the 2001-2003 era are either still in prison or have only recently been released. Financial figures like Bernie Madoff and Allen Stanford are too, though the top executives of global banking firms are not, despite a certain amount of public support for locking them up.

The simple truth is that under legal systems in most developed countries, to be convicted of a criminal offense requires proving that an individual intended on breaking the law, and then did so or compelled others to.

Corporations make a lot of mistakes, and sometimes engage in activities that offend the ethical sensitivities of others, or fail to comply fully with the voluminous regulations to which they are subject. Most corporations exist to make profits in competitive businesses that require them to develop what edges they can. Sometimes they overdo it. When they do, they have to face the consequences in civil courts where a payment of money is thought to be the best way to settle claims against them. If their conduct is considered to be especially objectionable, public opinion becomes a factor that can amplify the consequences.

VW’s admission that it knowingly installed 11 million devices to thwart emission regulations appears to be a case of criminal wrongdoing for which there will be a paper trail of responsibility. We shall see where it leads, but somebody had to approve the plan to install the devices, and probably a range of senior officials knew about it.  German prosecutors have shown themselves to be completely indifferent to the status of individuals they regard to be responsible, and the publicity surrounding the VW incident (reminiscent of Enron) only makes its executives more vulnerable to being charged with a criminal violation.

Duty of Boards

The question of whether boards can be expected to prevent corporate misconduct is one with a long history of unsatisfactory answers. There seems always to be a regular flow of corporate scandals in which boards are shown to have failed to monitor executives adequately. Despite a fair amount of post-VW introspective huffing and puffing, this is not likely to change in the future.

The most important thing that boards do is to appoint the company’s chief executive.  That means choosing someone to be responsible for the company’s financial performance and for safeguarding its reputation. Most boards emphasize the former and take the later for granted. Some think it is a zero-sum game, in which aggressive growth policies come at the cost of increasing reputation risk.

In reality, however, most large company boards are unable to monitor CEOs carefully enough to prevent unforeseen events. This is because of the complexity of corporate operations, the sociology of boards and the limited time any one board member has to delve into details, especially if these are being concealed. Nor is there evidence that splitting the Chairman and CEO roles, or emphasizing long-term results in compensation arrangements makes much difference.

Some economists think that markets are more skeptical of corporate results and explanations, and accordingly are better monitors of CEO performance than a group of loyal and supportive board members, but there is not much evidence of this either.

It just may be that boards are not much good at preventing trouble. What they have to be good at, however, is cleaning up after the trouble – replacing CEOs as soon as evidence of trouble arises, conducting thorough, honest investigations to get to the bottom of things quickly, and then doing what they can to rebuild the company after the trouble.

There is some evidence that this is improving. CEO turnover, according to a 2011 Bloomberg study, was at an all-time high for the world’s largest companies. Certainly this is so for the global banking industry that has turned over the CEOs at nine of the top twelve firms since 2008, some more than once. Even so, the larger the enterprise, the longer it seems to take for boards to step in with a cleanup.

VW, however, has been quick off the mark. 

Time for a Change at Justice

by Roy C. Smith

This week the Deputy Attorney General of the US, Sally Q. Yates, “stung by years of criticism that it has coddled Wall Street criminals” (quote from New York Times), announced new policies to place higher priority on the prosecution of individual executives of corporations suspected of wrongdoing. “Corporations can only commit crimes through flesh-and-blood people, Ms. Yates, said, “and those responsible should be held accountable.”

Surely the shareholders of the world’s largest banks that have been forced to pay many billions to settle charges against them rather face criminal trials before uncertain juries would agree. Executives of banks, who are selected and monitored by their board of directors, are not supposed to commit crimes (fraud, larceny, whatever) nor do the banks’ owners (shareholders) want them to be tempted to do so by management urging, compensation or other incentives.

The Justice Department, however, appears unwilling to cede the banks the benefit of the doubt that the intention of their boards is to behave properly. Ever since 2008, the Justice Department has been the Obama Administration’s agent for blaming the banks for the financial crisis and the Great Recession that followed.

The public has accepted this effort to shift responsibility for the whole mess onto the banks, and to infer that their actions could only have been the result of criminal activity that should be punished by jailing responsible executives.

The only trouble is that, despite serious and thorough efforts, the government has not been able to build a case against any of numerous responsible executives of several major banks investigated since the crisis.

Some say that the lack of indictments after 2008 is because financial fraud is hard to prove and top executives insulate themselves purposefully from those who actually do things. This may be true, but after the collapse of several high tech companies in the early 2000’s, the CEOs of Enron, WorldCom and some other companies did go to jail and for considerable periods.

The fact that the Justice Department did not find evidence of crimes would ordinarily satisfy the public that there were no crimes, but not in this case.

You may think that the banks acted unethically during the mortgage-backed bubble, or that they made stupid mistakes, but neither of those allegations are criminal. Disputes between parties in business transactions over ethical missteps or mistakes usually are settled by negotiation or civil litigation with compensation paid for damages. The Justice Department should have nothing to do with such matters.

But, this time around the Justice Department elected to act of behalf of the public by taking a highly political moral stand against the “greedy and reckless banks.” It did so by threatening to sue the banks for unnamed fraudulent actions knowing that the banks would settle, even for enormous amounts. It forced the banks into a position in which they had to choose between a large, perhaps unfair settlement and facing a possible criminal trial, which if lost could be their end as happened to Arthur Anderson, Enron’s accountants, in 2002.

The Justice Department’s practice of bringing such lawsuits changed when Eric Holder, in 1999 when Deputy Attorney General in the Clinton Administration, published the first in a series of memos by Deputy Attorneys General offering guidelines on prosecuting corporations. For a corporation to be indicted it had previously been necessary to demonstrate that it engaged in, or tolerated, or failed to prevent criminal activities.  Holder added the idea that the extent to which a corporation “cooperated” with the Justice Department in its investigations was also a factor. These criteria included turning over information on executives, waving their rights to lawyer-client privilege, and denying payment of executives’ legal expenses. Later some of these were deemed too intrusive of defendants’ rights and were withdrawn.

Ms. Yates’ memo is the latest in the series, but it doesn’t reinstate any of the withdrawn criteria, only notes that to get “credit” for cooperating, companies have to report or identify suspected employees and turn over evidence against them “regardless of their position, status or seniority.”  

Most banks had already assumed they would have to do this if circumstances required, so in that sense Yates’ memo emphasizing individual wrongdoing is nothing new.

What might be new, and certainly would be welcome by the banks, would be Justices’ subtlety deciding it was shifting ground and was finished with its campaign of suing the banks. If so, it’s very subtle, and indeed may only be reassurance to the left that the Obama Administration has not given up on going after the bad guys.

Almost all of the senior-most executives serving in the major banks in 2007-2008 have been replaced and suffered considerable financial losses in the bank shares they held. Some have also been disgraced and left unemployable. They attract little sympathy, however, because, looking back, the banks clearly did turbo-charge their activities in a giant mortgage market bubble that ultimately burst.

But they didn't cause the bubble (low interest rates and enormous institutional demand for mortgage-backed securities did), or the liquidity collapse that forced the mortgage-backed securities to absurdly low levels that caused mark-to-market write offs, that in turn imperiled some of them sufficiently that they had to be bailed out. The government’s actions to rescue Bear Stearns and AIG but not Lehman Brothers further confused the markets and drove prices even lower.

It is now clear that the blame-the-banks posture taken by the government has hurt the banks and the financial system. Not only have the banks faced the huge legal settlements, their regulatory constraints have been tightened to the point that they are struggling to earn enough to cover their cost of capital, not a viable position for the country’s most important banks to be in.

We need strong and healthy banks to help us recover from the too-low economic growth rates we have experienced in the seven years since the crisis. It is time for the government to contribute to the effort to improve the banks rather than to continue to prosecute them.

Let’s hope that that is what Ms.Yates was really trying to say.

Its Just a Correction, Unless China Makes it Worse

by Roy C. Smith

China’s market crash began in June, but has accelerated rapidly since, despite massive intervention by government entities to stop it.

It has now triggered a sympathetic response from the world’s capital markets (the market value of which is about $230 trillion, according to a recent McKinsey report) and stock prices in Europe, Japan and the US also slumped in another example of global market linkage.
These global market corrections have developed a tendency to be sudden and steep when they kick in.
However, they are always in response to three fundamental factors.
First – digesting the new news. China’s economic slowdown is not new news at all. Nor is its effect on global commodity prices, including oil. Clearly, a slowdown to probably less than 7% annual growth from 12% five years ago was going to affect other markets and investors have had plenty of time to make adjustments.
China’s intervention to attempt to stimulate growth in 2014 is not new either – China was expected to use its vast power in the economic realm to improve things, despite a commitment of some sort to allowing market forces to have more influence.
One consequence of the stimulative effort, however, was the enormous bubble in Chinese stocks that began about a year ago. The bubble has now burst; with all the usual effects, but, even so, the Shanghai Composite is only back to about where it was when the bubble began.
What is new is the fact that even after $200 billion of government-mandated purchases of equities, the Chinese market continued to drop sharply. This has forced China’s massive intervention to switch back to lowering interest rates and easing money, a move that may not work either but certainly will increase risk in the already bloated credit sector. China has serious political and economic issues ahead, but not all of these have global consequences.
Second – psychological forces are released. These are several. A major one may be that investors may no longer consider China to be an invincible economic superpower; instead conventional wisdom may have changed to regarding China as (only) a large but troubled emerging market economy with lots of growing problems.
But a global markets move of this magnitude – this is the fourth time that the VIX (US volatility index) has exceeded 40% since 2008; most of the time it has remained below 20% – unleashes investor responses typical of behavioural economics (and originally described by Keynes in the 1920s). It’s not what the investors think about all this that matters, its what they think other investors will do. If there is likely to be a sell off, these investors will want to act first to get in ahead of it. This means that corrections, when they come, are accelerated, at least until the expectation of what others will do changes.
Third – the underpinnings of the technology driven marketplace are not what you think. There are now a multitude of so-called exchanges on which stocks can be traded electronically. The NYSE and Nasdaq today only account for 25% of trading in US equities – so when a sell off occurs there is a frantic search for liquidity. Banks and broker dealers are also less active as market-makers than they were due to regulatory changes.
But it is more than liquidity. Around 30% of all equity trades today are in passive indices or ETFs, which have to be rebased when markets move rapidly. This is more difficult to do when circuit breakers designed to lower volatility are triggered. In turn this complicates pricing in the equity derivatives markets, leaving all of it in a twisted mess of mispricing until things get back to normal. So the prices you see in the midst of a crisis may be illusory.
But illusions can result in bad judgements. In 2008 a long but slow adjustment was already taking place in the overleveraged mortgage finance sector. These adjustments endangered a number of firms with heavy exposures, but there was no real avalanche until September when the US government wrong-footed markets by allowing Lehman to fail, AIG to live and embarked on several months of unpredictable interventions in markets to save the banks and automakers. This resulted in a rapid acceleration of psychological factors that panicked markets and led to a sharp fall off in GDP growth, which then became new news to which markets further had to adjust.
Most investors survive global market sell-offs with cool heads. They reflect on what is really new, and how much of the adjustment is driven by psychological factors and stresses in market pricing. Governments, however, may be more inclined to jump in and do something, even though increasingly evidence is developing that market intervention can make things worse, sometimes much worse.
China has intervened in this episode in massive ways, spending vast amounts in efforts to stabilise both the stock market and the yuan, without lasting success. It has also intervened in lending markets to extend a credit bubble within China that had already pushed total debt to 250% of GDP.
China has acted as if it has unlimited confidence in its ability to override market forces, despite evidence that this is not the case. It needs a cooler head to intervene less and let market forces restore equilibrium. So far, there is little sign that this will happen, but China may be learning more from experience than we know.

From eFinancial News, Aug 28, 2015

Street Smarts Reconsidered

By Roy C. Smith and Ingo Walter

Now that Tom Hayes, a 35-year old former Citigroup and UBS trader, has been sentenced by a British court to 14 years in jail for attempting to rig LIBOR, young people keen on building careers and fortunes in high finance should stop and think. His defense was a common one for traders in trouble: He did not know that what he was doing was illegal, his bosses were fully aware of what was going on, and anyway it was common practice among all of the global banks.

The jury didn’t buy it, and convicted him on all eight counts of conspiracy to defraud. Hayes will be almost 50 when he gets out, the best part of his life gone, permanently barred from returning to his profession, and who knows about his wife and child?

Back in 1997, after an earlier run of financial misconduct prosecutions, we wrote a book called Street Smarts – Linking Shareholder Value with Professional Conduct in the Securities Industry.  There were two basic themes. First, for financial firms and their shareholders, “reputation loss” was likely to far exceed any gains from misconduct, and so firms had to learn to manage the risk - with persistence backed by sufficient resources.  Second, for finance professionals, the risk-adjusted “expected value” of carefully staying inside the rules over a full career far exceeds the value of breaking them.

Few paid much attention - in an industry where “the long term is after lunch” and memories are short as people, products and strategies turn over rapidly, everyone is preoccupied by the constant search for an “edge” in markets that became hypercompetitive. And so, in the years since our book was published there have been several waves of scandals, each separated only by a few years.  And, as we predicted, the cost of reputation loss among major banks and other financial firms has been enormous, almost enough to destroy the industry.

Should shareholders care? Since 2008, the world’s top global banking firms have traded at book value or less – compared to roughly twice that historically. Legal settlements with government prosecutors have amounted to about $200 billion. Prosecutors have extracted guilty pleas to civil fraud or criminal charges from a number of the world’s most prominent financial firms, though none have availed themselves to their right to trial. Bank regulation has been totally revamped, and made much stricter. Even so, central banks and other regulators still treat the word “culture” with suspicion and have arranged a number of “qualitative” stress-test requirements focused on good behavior that bankers must meet.

The public has shared in the regulators concerns, and in some quarters has agitated for the bankers that wrecked the system in 2008 to go to jail. Top executives at all of the banks have been closely investigated without finding sufficient evidence to bring criminal charges. But, since 2007, two-thirds of the CEOs of the twelve largest global banks have been replaced, along with a large number of unit heads. Most of the highly paid mid- and senior-level executives from the time of the Crisis have lost a great deal of their personal wealth held in the shares and options to buy stock in their firms. Many also lost their personal reputations, and have become unemployable in their professions.  Some have become a laughing-stock or poster-boy. Others keep their heads carefully below the parapet.

So the allegation that banks and bankers got off scot-free is not true.  But maybe it’s worth repeating some of the lessons that we learned almost twenty-five years ago.

First, beginning in the 1980s, banks stopped being viewed largely as public utilities or (in the case of independent investment banks as small focused professional firms) as deregulation, globalization and technology combined to transition them to trading-oriented, high-margin growth firms. Such an extensive transformation changed the industry’s risk exposures considerably. With the change in strategy came much greater risk, not only from trading but also from competitive dynamics that pushed firms towards a morally ambiguous, “you eat what you kill” business culture. Transparency became an enemy. Valued clients became mere trading counterparties.

Second, the new competitive culture quickly transformed compensation practices into a turbocharged pay-for-performance model, which altered who was getting rewarded, how much and what for - without full recognition of associated risks, including hard to assess regulatory and reputation risks. Traders pushed out to the riskier end of the market and behavior patterns changed to justify almost any potentially profitable activity that was not obviously illegal. These notions jumped from firm to firm via chat-rooms and a high-mobility mindset that expected little loyalty from employers and gave little in return. Moral and business conduct issues became ambiguous and often were set aside. The ancient ideas that “if others are doing it, it must be all right” and “if we don’t do the business someone else will” reappeared essentially unchanged from the preceding scandal.  Nothing much was learned.

Third, managing the moral and ethical components of risk was new, difficult to evaluate, and attracted little support from the top beyond fervent lip service. No one wanted to pay for it either, whether out of pocket or by foregoing profitable business opportunities.  The longer this attitude persisted, the more inculcated it became in firm cultures.  So, reputation loss was an unmeasured crisis waiting to happen – and when it came, it did so with a vengeance.

Fourth, professionals working in such firms had to follow a difficult script. Attracted by and comfortable in precisely this just this kind of culture, unless they were very watchful and careful while at the same time treading softly and going with the flow it was easy to imperil their careers.  Once their firms felt the sting of reputation-related losses and penalties, so did all employees compensated via bonuses linked to the share price. When the stock price tanked so did the personal wealth of employees from Drexel Burnham, Bear Stearns, Lehman Brothers, AIG, Citigroup, Bank of America, and many others.  And during times of trouble many competent employees (including people who had nothing to do with any misconduct) were fired or otherwise let go in periodic waves of lay-offs and cost-cutting.

Fifth, few employees that engaged in misconduct seem to have understood the basic math. To adjust what may seem like a large difference in compensation from creating more profit for the firm, one has to estimate the probability of getting caught and the consequences that will follow (financial and otherwise).  The probability of being caught may be low - although the technology that is your friend can be turned against you very quickly to locate a smoking gun, and there are plenty of people up and down the line who can squeal on you.  And adverse consequences applied over a full span of a 30-year career are almost infinite: Loss of accumulated fortunes (through stock losses and clawback provisions), loss of future income, fines, personal and familial shame, and possibly even incarceration.

Despite efforts by some firms to reward internal monitoring and increase surveillance, the industry as a whole seems to have failed in learning how to manage these risks and still satisfy shareholders that they are performing well against the competition. Market discipline has, in effect, failed as a behavioral and cultural safeguard.

So the big fist of public policy has been applied, and financial firms have been forced to improve by Dodd Frank and other extensive regulatory efforts that have made it nearly impossible to compete as they once did.  Some are reverting to the public utilities they used to be, others are focusing on less risky areas like asset management where they see a competitive advantage. A few are doubling-down on trading in securities markets and striving to reengineer themselves to remain leaders – knowing that the future risks of misconduct are ever-present. Each has its own behavioral and cultural traps, but at least they are easier to identify and perhaps to manage effectively.

However business models evolve in global finance, all of the incumbent firms and new entrants will have to learn to manage internal misconduct risk far better than ever before. It’s now a matter of survival.

August 21, 2015_

The US Should Privatize its Infrastructure

By Roy C. Smith

We are told that public infrastructure investment creates jobs and efficiencies, and should easily be financeable, but politics prevent this from happening.  Privatization can help.

The American Society of Civil Engineers recently awarded the US a minimally passing grade of D+ for its crumbing infrastructure, and identified $3.6 trillion of unfunded requirements.

This is because US public infrastructure (highways, bridges, airports, etc.) is paid for by user taxes and tolls that politicians are loath to raise, or by direct government grants that are equally unpopular.  Thus, it is continually under-depreciated, under-maintained, and under-financed.

The New Jersey Turnpike (constructed in 1951) is in poor shape and needs to be improved and renovated. In 2007, Governor Jon Corzine proposed a $30 billion sale/leaseback arrangement, but the New Jersey Legislature would not approve it because doing so was feared to involve job losses and wage cuts, as well as raising the tolls. The current toll to travel the turnpike’s entire 122-mile length is less than the cost of crossing once over the 1-mile George Washington Bridge. Raising the toll, about half of which is paid by motorists passing through the state, is still politically toxic in New Jersey.

The Tappan Zee Bridge over the Hudson River was constructed in 1955 with an expected life of 50 years. The bridge is now being replaced at a cost of $5 billion that has not been funded by the NY State legislature. Raising the toll from $5 appears to be completely off the table (the George Washington Bridge’s toll is $14).

The US Highway Trust Fund, established in 1956 to fund and maintain the federal highway system by assessing a national gasoline tax (last updated in 1993 at 18 cents per gallon), would have run completely of out money last month except for a last-minute, three-month, $8 billion fix. This does little to address the $92 billion deficit that the Congressional Budget Office expects the Highway Trust Fund to run over the next five years.

The simple truth is that public infrastructure is fully financeable as long as tolls are set at rates sufficient to generate revenues to cover capital and operating costs. If so, bonds issued by the entities readily can be sold to investors in global capital markets.  New entities such as Infrastructure Banks are not necessary. What is necessary is getting agreement on how to set up infrastructure projects at market rates so they can be financed and we can get on with them.

In other words, a kind of privatization needs to be applied.

In Europe, privatization began in the 1980s and resulted in several hundred billions of dollars of sales of shares in state-owned-enterprises, including portions of the national highway system in France, Spain and Italy.

These programs involved acute political struggles at first as opponents feared job cuts, wage reductions and rate increases, and resented the idea that rich people would end up owning all the public goods.

But it wasn’t just Mrs. Thatcher and her Tories who became believers; most of the rest of Europe, Latin America and Asia joined in as the positive results of privatization became clear.  The enterprises, required to follow economic laws of the marketplace, became profitable, paid taxes, made new investments and increased employment once they returned to a growth mode. If they didn’t they would be taken over by other companies or private equity funds that would try again.

In America, however, there are very few state-owned-enterprises. Instead, the idea of regulated “public utilities” was preferred. This meant that potentially monopolistic, but very capital-intensive energy, water, transportation and other companies could remain in the private sector if state or federal utility commissions regulated their rates and other activities. These private sector companies have been successful and are not the ones getting failing grades from the American Civil Engineers. They fund what they need as they go along.  In 2014 these types of companies raised $750 billion in global capital markets.

The ones with the failing grades are the government owned “public goods” enterprises that operate highways, passenger rail, airports and other systems that are used by the public at large and are important to the economic infrastructure of the country. The public expects these goods to be provided by the government at a cost that is affordable and fair, but it is also capable of resenting the subsidies that are necessary to keep fees low.

The system for funding public good infrastructure, however, has collapsed into a morass of politically overlapping jurisdictions of federal, regional, state and government-sponsored corporate entities that politicians are reluctant to fund.

For example, a 104-year old railway drawbridge in New Jersey carries 450 trains a day into and out of New York City. It is owned by an under-funded government-sponsored-enterprise called Amtrack, but also carries commuter trains operated by under-funded NJ Transit. The drawbridge, when opened, frequently fails to close properly and causes massive travel delays. Amtrack needs $1 billion to replace it, but it is unable to either raise it or get the federal or New Jersey government to pay for it.  The bridge, which is typical of many such bottlenecks in the US transportation system, remains un-improved.

The system clearly needs to be changed. One idea to do so is to separate transportation public goods and public utilities based on re-consideration of the subsidies.

The Highway Trust Fund, NJ Turnpike, Tappan Zee bridge and the ancient railway bridge are all part of a federal interstate transportation system that is large and robust enough so as not to require subsidies. If left alone to do so, it could fund itself (as gas and electric utilities do) but at present each part has to fund itself.

Congress could authorize an “integrated federal interstate transportation system” to operate as the governing public utility regulator for government controlled assets in the transportation industry.  It could take over decaying infrastructure from states that are unwilling to pay to upgrade it, and privatize it, either by resetting user fees to market rates or by selling it to private operators.

This would get state legislatures out of the rate-setting business, and could enable them to recover some of the proceeds from privatization sales. Considering the dismal financial condition of many large states, this should be a very welcome proposition.

Congress then might even be able to abolish the federal gasoline tax, releasing transportation infrastructure finance from the crippling constraint of ongoing partisan politics.

Privatization solved a lot of problems in Europe after facing a lot of the same political issues.  It is time for the US to apply some of the lessons.

From: eFinancialNews, Aug 10, 2015

Greece is a Mess - but China is the Real Worry

By Roy C. Smith

Three trillion dollars. That’s the amount wiped off the value of shares in China over the last three weeks. That’s about ten times the GDP of Greece.  The government is forcing a rescue of the plunging market, but will it hold? An avalanche in China would be far more consequential than Greece leaving the euro.

There are big differences between the strategies employed in Athens and Beijing as they wrestle with their problems.

Greece is trying a “tyranny of the weak” strategy: if you won’t give us better terms, we will die on your doorstep. It is unlikely to work in the long run. Despite its referendum, Greece is broke, and will have to restructure.  How it does so, and over what time period, is really a European political issue that will go on long past the present deadline.

China, on the other hand is pursuing a “tyranny of the strong” approach: we are powerful enough to be able to make things the way we want them. However it has no more likelihood of success than the Greek strategy.  Applying government resources to manage markets (sorry, that should be to “uphold market stability”) is hugely expensive, creates a lot of other problems, and cannot be sustained for long periods.

Over the past year or so, China has used its authoritarian powers to stimulate financial markets to reverse declining growth through a combination of liquidity measures and policy changes aimed at increasing credit availability and stock market investment.

Lots of money has been poured into shoring up weak local and municipal governments and state owned enterprises, and to increase margin credit for stock purchases.  Clearly, there has been an orchestrated effort by the Xi Jinping government to manage markets for political purposes, which have included creating a bull market to encourage confidence in further economic growth.  

But the bull market became a bubble, and the bubble began to burst into free-fall, requiring further intervention to shore it up.

Over the past three weeks these efforts have become extreme. Among them are are halting trading in half of all listed shares, suspension of IPOs, halting short-selling, directing its sovereign wealth fund and public pension funds to increase stock purchases, and creating a Market Stabilization Fund by 21 “willing” brokers who have agreed to invest additional $20 billion in stocks, and not to sell any stocks while the Shanghai market index is below 4,500 (after a recovery in the last two days, it’s currently at 3,877). $20 billion may be only 0.16% of the $12 trillion market capitalization of the various Chinese markets, but it surely is a lot to the 21 brokers who have agreed to provide it.

Will the government’s effort be able to stop the rout?

Certainly, they might. China has vast resources that could be applied. So far, however, the government seems to be relying on its power to tell people what to do rather than on its deep pockets.  

Japan, which suffered a similar market crash in early 1990, also intervened extensively (to the extent of about 0.8% of market capitalization) to halt the decline, which, like China’s, reached 38% after the first few months. It worked for a while, but not for long. Two years later, the Japanese market index had dropped 65% from its pre-crash peak.

Once the Chinese government decides it has stabilized the stock market sufficiently, and withdraws the extraordinary measures, it is likely that the market will find very little support. 

Eighty percent of Chinese stocks are owned by the country’s 400 million urban middle-class. These investors, who have trusted the government’s economic policies, have already lost a lot of money and many have suffered calls on margin loans that, in response to stimulus efforts, now amount to about $1 trillion.  

Some of the suppliers of margin credit, such as smaller banks, financial intermediaries and government agencies (e.g., China Securities Finance, which was told to increase margin lending to stop the decline) will be endangered, and may been to be bailed out in order to prevent further panic in the markets.

Loans made to shore up weak credits will increase China’s abundant supply of non-performing loans, causing either bankruptcies or further intervention by the government to paper them over

What confidence China has earned from the world and its own prospering middle class in gradually adopting market economics will be lost, and what transparency there has been will be sacrificed as cover-ups spread throughout the system. Most important, a loss of confidence in the Chinese economic miracle would greatly imperil the government’s paramount objective of reversing a declining GDP growth trend.

Because China isn’t a democracy, President Xi has more power than the other leaders. He can make bigger bets that he can override market forces. But, even in China there are factions and rivals that raise the stakes for President Xi to avoid an economic meltdown.

The urgency of addressing the stock market decline has pushed proper, long overdue economic reform into the background. A portion of a World Bank report earlier in July urged China to accelerate reform of its state-dominated financial sector. "Wasteful investment, overindebtedness, and a weakly regulated shadow-banking system," had to be addressed for China's broader reform agenda to succeed, it said. The report also warned that failure to address these issues could end "three decades of stellar performance" for the world's second-largest economy.

China’s response was to request that the offending portion of the report be withdrawn, which it was.  Indeed, since then, rather than thinking about ways of reducing state intervention it has ramped it up. Reforms, if the words can ever be applied to a system so dependent on government intervention, will have to wait until fears of the China bubble bursting are over.

In many areas of policy Beijing’s ‘tyranny of the strong’ mindset works. And in this area too, it may appear to work for a while.  Markets can be propped up, with effort, for months or even a year. But then there is a moment when the markets want no more of it, and start to collapse. Despite efforts to counter it, the collapse gathers steam and can end up as an avalanche.

from eFinancial News, July 9, 2015